The rise and fall of the unicorns

Some private technology firms are having trouble justifying their lofty valuations

WORKERS from technology firms recently gathered at a cinema in downtown San Francisco to watch a preview of “The Big Short”, based on the bestselling book by Michael Lewis. The film, which will be released in December, profiles several outsiders who successfully bet against the housing market when everyone else believed it would continue to rise, as it always had. You already know the ending.

Some viewers in the audience must have seen it as a disturbing reminder of how dramatically momentum can shift. Technology companies are unlikely to experience a meltdown as severe as the housing crisis, but an industry that only yesterday was all promise and optimism is showing signs of cooling.

In the last quarter several mutual funds, including Fidelity, have marked down the value of some of their holdings in unlisted tech firms. Fidelity wrote down Dropbox, a cloud-storage firm, by 20%; Snapchat, a messaging app, by 25%; and Zenefits (software) and MongoDB (databases) by around 50% each. All are “unicorns”, that is, tech firms which have yet to come to the stockmarket but are valued at $1 billion-plus. These are seen as having the brightest of prospects among startups of all kinds. Zenefits, for example, had raised money at a $4.5 billion valuation in May. Valuations for private technology firms are rising at a slower clip than they were six months ago. On November 24th Jet, an e-commerce competitor to Amazon, announced that it had raised $350m (valuing the firm at $1.5 billion), a big sum for a loss-making startup, but a lower one than it had first hoped for. Recently Airbnb, a fast-growing room-rental firm, raised $100m, but reportedly stayed at its recent valuation of $25 billion, instead of rising further. Fred Giuffrida of Horsley Bridge, a firm that invests in private-equity funds, reckons that the valuations in late-stage rounds of financing have declined by around 25% in the past six to eight months. These rounds are also taking slightly longer to complete.

Mutual funds do not comment on the rationale for such markdowns, but it is believed that these unicorns have not met their growth targets. Stockmarket volatility may be another reason: investors value unlisted firms by comparing them with similar listed ones. That can work in private firms’ favour at times, but undermines them when stockmarket valuations fall, says Jeremy Philips, a partner at Spark Capital, a venture-capital firm.

It has become clearer that the high valuations firms achieve in private are not always maintained when they go public. This month’s listing of Square, a payments company, valued the firm at around $4 billion, around a third less than in its most recent private round. Other firms have also suffered “down rounds”, or devaluations, too (see table). An especially poor performer is Etsy, an online marketplace for handmade goods, which is 70% below where its shares traded when it went public in April.

Many investors in unicorns had bet that a new generation of technology firms would unsettle the old guard, but that has not happened as quickly as they had predicted. Tech giants like Amazon, Google and Facebook have continued to grow impressively, especially considering their already large size; and they have been adept at entering new markets that startups might otherwise have claimed. For example, Facebook has bought and built messaging apps that compete with Snapchat, and Dropbox has a rival in Amazon, whose cloud-storage business is large and growing quickly. Compared with most profitless startups, the big firms are not outrageously valued. It may become clearer to investors that they not only overestimated the unicorns but underestimated the incumbent firms’ growth prospects.

The mood among some backers of startups has become more cautious. Fewer specialist technology investors are taking part in new financing rounds. General investors such as hedge funds, asset-management firms, oligarchs, princes and sovereign-wealth funds are filling the gap. Fidelity led the most recent round for Jet, which some specialist tech investors see as a lemon of a business, as it bleeds money trying to undercut Amazon. In September Baillie Gifford, a Scottish wealth-management firm few in Silicon Valley have heard of, led a round of funding for Thumbtack, which helps skilled workers find jobs, valuing the startup at $1.25 billion.

With investors, until recently, throwing money at them, the unicorns have got into the habit of burning through their cash in an attempt to buy market share. Lyft, a taxi-hailing firm that is a rival of Uber, reportedly suffered losses of nearly $130m in the first half of this year, on less than $50m in revenue. Instacart, a food-delivery firm, is rumoured to lose around $10 on each order it fulfils. Such practices are only likely to stop when the funding for these firms dries up, or investors whip them into shape.

Another ill-advised but common practice among the unicorns is their habit of pumping up their valuations and giving outsiders a misleading picture of what they are “worth”. In an effort to make their supposed valuation go up each time they raise funds—so as to suggest that they are making good progress—many firms are agreeing to investors’ demands to attach special privileges to the shares being sold. In theory, if an investor pays $100m for a 10% stake in a firm, that implies a valuation of $1 billion; but if the investor attaches conditions to the purchase that guarantee him a return or will give him his money back first, it means the effective valuation being put on the company might no longer really be $1 billion. An investor might be happy for the company to talk as if it has achieved the $1 billion valuation as long as he has his extra guarantees.

To participate in late-stage financing rounds, many investors are asking for favourable terms such as “liquidation preferences”, in which it is promised that they will get at least their money back and sometimes a guaranteed return on top. In other cases, investors are offered “ratchets”, in which they will receive extra shares in compensation if the firm’s valuation is reduced when it lists on the stockmarket. Late-stage investors in Square were protected with ratchets, so they are likely to have made a good return even though it went public at a reduced valuation.

The unicorns’ employees, whose holdings of common stock are diluted by these protections, are among the main losers from all this. Firms do their employees “a disservice with their high valuations,” says James Park, the boss of Fitbit, a maker of fitness-tracking devices that went public in June. “I don’t think a lot of people realise that once preferred stock and liquidation preferences come in, their common stock isn’t worth much.” He also says private firms are much more “cavalier” in claiming that they will grow to become $20 billion-30 billion firms. This helps attract employees, but may mislead them.

The tech industry’s herd of unicorns contains many beasts that look awfully similar to each other, or to longer-established firms. Yet many are being valued—in as much as the valuations are believable—as if they were guaranteed to be among the long-term winners in their line of business. In fact, not all can survive. Weaker firms have been able to keep going because money has been so easy to raise. And their spendthrift ways have made it harder for stronger rivals to control their own costs and make a decent profit. If investors are now becoming more cautious, that should lead to a healthier climate in the tech industry.

Firms that are still perceived as winners, such as Uber, will not have any trouble raising new money, no matter how severe the contraction in funding. The pain of a slowdown will be felt most by firms that have lots of other tech firms as clients. Food-delivery, catering and taxi-hailing firms get lots of business in San Francisco and Silicon Valley from tech firms that subsidise meals and rides for their employees. Firms that offer online monitoring tools or recruiting services also depend highly on tech companies for business. So do bigger firms like Twitter and Facebook that have benefited from the boom in tech firms’ advertising, says Gil Penchina, an investor, who says he has been trying to avoid exposure to this breed of firm.

In past downturns healthy and well-capitalised firms have benefited, says Sander Daniels, a founder of Thumbtack, who points out that Google had its “pick of the litter” of top engineers after the dotcom bust over a decade ago. Those firms that loaded up with cash in good time for the downturn will also do well. Airbnb, for example, has around $2 billion in cash, and a burn rate of around $100m a year. If the housing boom-and-bust taught any lessons to Silicon Valley, it is that the rich tend to bounce back most quickly. This will be true of the tech industry as well.